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The Tax Cuts and Jobs Act of 2017 provided significant changes to the net operating loss (“NOL”) system for corporate and individual taxpayers, including:

NOL can no longer offset all of a taxpayer’s net income in a subsequent year. Instead, NOLs can only offset a maximum of 80% of net income. For corporations, this rule effectively produces a 4.2% minimum tax rate on current year income, regardless of the magnitude of its NOL carryforwards.

NOLs can be carried forward indefinitely (instead of for only 20 years), but generally they can no longer be carried back to prior years.

These rules are generally effective for NOLs arising in taxable years after 2017; NOLs generated in prior years will be subject to the old rules. As such, businesses with historic NOLs will effectively have some phase-in time as they use up their historic NOLs.

Growth companies have few resources in abundance other than talent, enthusiasm, and NOLs. Unfortunately, these changes make the NOLs less valuable. Consider these situations:

Reaching profitability. If a growth company became profitable after years of incurring losses, NOL carryforwards could shelter its net income from tax for several years. Now, at least 20% of its net income will always be taxable. For a company with boom and bust years of alternating profits and losses, the timing of income and expenses is suddenly important; and they may want to find a way to “smooth” earnings if possible. Needless to say, this is a substantial complication in tax planning.

M&A targets. Growth companies going through an exit event may feel the sting in two scenarios.

First, a company that was never profitable may nevertheless have significant capital gains from selling its appreciated assets, like IP or goodwill. It may face a tax liability notwithstanding a bounty of NOL carryforwards. Worse, the target may then liquidate or otherwise not earn a net profit again, rendering the unused NOLs permanently worthless.

Regardless of deal structure, previously profitable M&A targets often generate net losses in the year of sale because of one-time, transaction-related deductions, such as sale bonuses, option cash-outs, etc. By carrying back the resulting NOL, the target or its shareholders could generate a nice windfall of extra cash in the form of a prior year tax refunds. Eliminating NOL carrybacks forecloses this strategy. Instead, owners of S corp and partnership targets will need to wait for future net income. Owners of C corp targets may try to negotiate a purchase price adjustment with the buyer. Although the NOLs may now be carried forward indefinitely, buyers will generally be ungenerous to such efforts. On top of the 80% limitation described above, annual use of the NOLs will still be generally limited by the Section 382 “ownership change” rules. Further, buyers traditionally chafe at the tax benefits sellers enjoy from paying transaction-related compensation and other expense, financed of course by the buyer’s cash.

The Tax Cuts and Jobs Act of 2017 may consist of more than 1,000 pages of statutory text and committee explanation, but the top headline is simple: “21% Corporate Tax Rate.”

More specifically, the graduated tax rates for C corporations that maxed out at 35% have been replaced with a 21% flat rate. Though broadly applying to all worldwide income of U.S. corporations, the consensus view is this dramatic rate cut has an international audience.

Related Legislative Changes

Repeal of corporate AMT. There would be no point to a new, flat 21% tax if corporations were still subject to an alternative minimum tax that kept their effective tax rate higher. The corporate AMT has been repealed. (In another post, we’ll describe how the individual AMT wasn’t repealed, but will apply to far fewer taxpayers.)

Reduced DRD. When corporations own stock in other corporations and receive dividends, the double-tax on corporate earnings distributed to shareholders can become a triple-tax, quadruple-tax, etc. To dampen this effect, corporations are entitled to a “dividends received deduction” (DRD) permitting them to exclude from income all or a portion of such dividends. The percentage of exclusion depends on the upper-tier corporation’s percentage of ownership of the lower-tier corporation. For dividends from ≥ 80% subsidiaries that could (or must) file a consolidated return, the DRD is and remains 100%. But as a revenue offset to the overall corporate tax cut, the DRD has otherwise been dialed back. For ≥ 20% subsidiaries, the DRD has been reduced from 80% 65%. For “portfolio investments” of corporations (< 20% ownership), the DRD has been reduced from 70% to 50%).

Some Practical Consequences

C corporations more attractive generally. The 21% rate obviously makes C corps more attractive as a form of business organization when compared to the top 40.8% rate that could apply to individuals earning flow-through income from S corps and partnerships. (The new top individual rate of 37% + 3.8% Medicare tax = 40.8%.) We will dive deeper into the choice-of-entity issue in a later post, but suffice to say this may change the choice-of-entity calculus for both new and existing companies.

Recompute the “double-tax rate.” A lot of business decisions, from choice of entity, to paying compensation vs. paying dividends, to preferred M&A transaction structure, require a rough application of the corporate double-tax rate, e., the aggregate taxes on $1 earned by a C corporation, which then distributes the after-tax earnings to shareholders. The double-tax has long been over 50%, and maybe over 60% counting state taxes. Now, once a C corp pays 21% corp tax and distributes the after-tax balance to an individual shareholder who is taxed at 23.8%, the maximum federal double-tax should be 39.8%.

Retained earnings — incentive & limitations. Of course, the double-tax only applies if a corporation’s after-tax profits are distributed as dividends. A C corp that retains its earnings can defer almost half of that tax until some indefinite future time. There are, however, important limitations on this strategy:

Shareholders may want or need cash. Not to be underestimated.

Accumulated earnings tax. Once upon a time, before Ronald Reagan, there was an even greater disparity between the top individual and corporate tax rates than prevails today. The C corp rate was 35%, but the top individual rate was a whopping 70%. Even when the top rate was decreased to 50% in 1981, dividends were taxed at ordinary rates. The rational and widespread retention of C corp earnings led to the “accumulated earnings tax” (AET), which imposes deemed-dividend treatment where a C corp’s retained earnings exceed “the reasonable needs of the business.” (Fun fact: the AET is one of the only federal taxes that is not self-assessed; it is only payable when imposed by the IRS.) Largely irrelevant during the decades of parity between the top individual and corporate rates, the AET may now make a comeback.

Personal holding company tax. Another product of sky-high individual tax rates, the “personal holding company” regime has renewed relevance. Certain closely held C corps with high proportions of passive income face an additional 20% tax. Be careful with that ingenious plan to put retained earnings to work in passive investments.

Section 269A and service corporations. The TCJA has prompted lots of speculation and criticism in the popular and business press surrounding whether employees can and should provide services through personal C corps. Read the fine print, in this case Section 269A, which authorizes the IRS to re-allocate income between an individual and a personal service corporation formed to provide service to a single employer. In other words, the IRS can ignore the corporation and treat the employer as paying the individual corp owner directly.

The Tax Cuts and Jobs Act of 2017 (“TCJA”), the most significant revision of the U.S. income tax laws in 30 years, is now the law of the land. We’ll be rolling out plain-English summaries of the most important business tax changes and what they mean to growth companies and their advisors, including the dramatic cut to the corporate tax rate, the 20% exclusion on “qualified business income,” a radically different approach to international taxation, important changes to net operating losses, and much more. We’ll also take a step back and assess how the TCJA impacts perennial tax questions for growth companies, like choice of entity, M&A structures, and equity compensation strategies.

In what passes for “news” regarding 83(b) elections, the IRS recently issued final regulations that eliminate the need to attach a copy of an 83(b) election to the service provider’s federal income tax return for the year of the election. The change is intended to encourage the electronic filing of tax returns, which isn’t available if one needs to attach non-standard forms and statements like an 83(b) election.

To be clear, taxpayers still need to submit a paper copy of the 83(b) election to the IRS within the applicable 30-day deadline. The final regulations apply to property transferred on or after January 1, 2016, but taxpayers were already permitted to rely on identical, previously proposed regulations for transfers on or after January 1, 2015.

While we are on the topic, we should seize the opportunity to answer some of the most commonly asked questions about 83(b) elections. Although the rules are written more generally to apply both to employees and independent contractors, to any kind of restricted property, and whether the property is transferred to the service provider or a third party, let’s focus on the typical situation where you are an employee receiving unvested stock of your employer as compensation for services.

Q: What does an 83(b) election do?

A: As background, when property is transferred in connection with the performance of services, Section 83 governs the timing and amount of compensation income taxable to the service provider. The general rule is that the vesting date governs both the timing and amount of taxable income. That is, you recognize taxable income in the year in which the stock is substantially vested, in the amount of the difference between the stock’s fair market value on the vesting date and any amount you paid for the property.

The function of an 83(b) election is to make the grant date the relevant date, rather than the vesting date. That is, you have taxable income as of the grant date, based on the fair market value of the property on that date.

In either scenario, upon the “compensation event” (i.e., the vesting date or grant date, depending on whether the 83(b) election is made), the income is taxable at ordinary rates and your holding period in the property begins. Any further appreciation or depreciation of the stock is capital gain or loss.

Q: Why would I want to file an 83(b) election if doing so will accelerate my income?

A: True; normally you want to defer rather than accelerate taxable income. But the difference between the tax rates for ordinary compensation income (39.6% max.) and long-term capital gains (20% max.) may change your calculus. If you expect the property to both increase in value and eventually vest, the 83(b) election allows you to start your holding period (long-term capital gains treatment requires you hold the property for more than a year) and apply the lower capital gains tax rate to any further appreciation. Without an 83(b) election, the taxable income is deferred, but any appreciation between the grant date and vesting date is taxed as ordinary income instead of, potentially, long-term capital gains.

Q: Why would I not want to file an 83(b) election?

A: An 83(b) election comes with risks. If you forfeit the property, or if the property decreases in value (or becomes worthless) prior to vesting, you will have unnecessarily paid some taxes (an odious, despicable thought in our business).

You may think there’s a consolation prize in those scenarios. Because the property’s value on the grant date becomes your tax basis, you should logically get a capital loss if you later forfeit the property or dispose of it for a lesser amount. Unfortunately, under one of the most ludicrously unfair rules in the tax law, if you make an 83(b) election and later forfeit the property, your capital loss is limited to any amount you actually paid for the property out-of-pocket. In the event of a forfeiture, you get no tax loss for the amount previously included in your income by reason of the 83(b) election.

Q: So, how do I decide whether to file an 83(b) election?

A: As you can see, making an 83(b) election is a calculated risk that the possibility of a lower tax rate on future gains outweighs the certainty of immediate taxation at ordinary rates. As Dirty Harry would say, “Do you feel lucky, punk?”

In practice, the choice is easier for some service providers than others. For instance, if you receive early-stage company stock with nominal value, an 83(b) election has nothing but upside. At the other end of the spectrum, if the company is highly mature with a steady value, you will typically be happy to defer income and avoid the risk of forfeiting the stock prior to vesting.

Q: Can I file an 83(b) election if I receive stock options subject to a vesting schedule?

A: No, with a very narrow exception. An 83(b) election cannot be made on compensatory stock options unless the options have a “readily ascertainable fair market value,” which functionally means the options are publicly traded. But even this exception is narrower than it appears, since a company’s options that are publicly traded by investors have dramatically different terms than those issued under the company’s equity compensation plans (regarding length, strike price, application of SEC regulations, etc.). Translating the price of the former into a price for the latter is likely too complex to satisfy the “readily ascertainable” value standard.

Q: Do I need to file an 83(b) election if the stock is fully vested when granted to me?

A: Strictly speaking, no. Where property is fully vested when granted, this means the grant date and vesting date are the same, resulting in an immediate compensation event regardless of whether an 83(b) election if filed.

The complexity lies in determining whether the property is “vested” within the meaning of Section 83. For tax purposes, property is vested if it is either (1) no longer subject to a “substantial risk of forfeiture,” or (2) transferable to any third party free and clear of any forfeiture conditions (more on this later). We often equate a “substantial risk of forfeiture” with a requirement for future services, but it can be any compensation-related condition, such as a requirement that the individual or company reach certain performance targets. So think carefully about all conditions before concluding that stock is fully vested, and if in doubt, consider filing a “protective” 83(b) election.

Q: Should I file an 83(b) election if vesting restrictions are imposed on fully vested stock that I already own?

A: This question arises most in the context of preferred financing rounds, where founders holding fully vested common stock agree, as a condition of the financing, to subject those shares to vesting restrictions. It can also arise in the M&A context, where shareholder/employees exchange their existing shares for unvested shares of the buyer in a taxable or tax-free transaction.

The key question is whether a holder of fully vested property is receiving any “new” property that is subject to the vesting restrictions. If vesting restrictions are simply being applied to the founder’s current shares, no 83(b) election is required. What often happens, however, is the founders receive “new” shares of some sort, albeit in a tax-free way. For instance, as part of the financing, the company may reincorporate in Delaware or the company may recapitalize to increase or decrease the number of common shares. If the founder exchanges his existing vested shares for new unvested shares, an 83(b) election is required to avoid any further appreciation from being taxed as compensation income upon vesting. The election would not trigger any additional income – the founder has “paid for” the new shares by exchanging the existing shares of equivalent value.

Q: How do I file an 83(b) election?

A: Mail your 83(b) election to the IRS service center where you would mail a paper copy of your income tax return if you were not including a payment. You can find the appropriate address on the IRS website. You must also provide a copy of the 83(b) election to your employer and any person or entity to whom you transfer unvested property, such as an estate planning vehicle.

Q: What is the deadline for filing an 83(b) election?

A: An 83(b) election must be postmarked within 30 calendar days after you receive the restricted property. There are no exceptions, unless you are serving in the Armed Forces (or in support of the Armed Forces) in a combat zone, or the IRS determines that you are affected by a presidentially declared disaster or terrorist or military action.

The 30th day is calculated by counting every day (including Saturdays, Sundays and holidays) starting with the day after the date on which you receive the property. For example, if you receive restricted stock on April 19, your 83(b) election must be postmarked no later than May 19. If the 30th day falls on a weekend or holiday, then the deadline is the next business day.

Q: What if an 83(b) election contains a mistake? Can I file an amended election?

A: Once the 30-day deadline has passed, there is no process for amending an 83(b) election other than securing the IRS’ permission to revoke the election entirely. In terms of what impact a mistake may have on the election, there is no official guidance, but our attitude is to keep in mind the underlying purpose of the election, i.e., to commit the service provider to immediate taxation vs. waiting until vesting. So minor mistakes about your personal information, general description of the property, or vesting schedule will likely be disregarded. On the other hand, if you are issued 100,000 shares and list only 50,000 shares on the election, the IRS would be dubious if you claimed you really meant to make the election on 100,000 shares when their value skyrockets.

Q: What can I do if missed the deadline for filing an 83(b) election?

A: We knew you’d ask that. The most common question is also the most difficult. The 30-day deadline is hard and fast, and the IRS claims it lacks the authority to grant extensions.

First, let’s rule out having the company simply cancel and re-issue your stock on the same terms. The IRS will see through that sham in a second. Instead, the company could replace the stock with options or new stock with materially different terms.

If those solutions won’t suffice, there is another potential solution that we’ve employed in emergency situations. It’s ugly and must be customized to the specific facts, but it aims to accelerate the “compensation event” and reach the same tax result as if you had timely filed your 83(b) election. Recall that your stock is “vested” (and thus taxable in the absence of a timely 83(b) election) when there is no longer a substantial risk of forfeiture or the stock is transferable to a third-party free of the forfeiture risk. Understandably, the company will not want to waive the vesting schedule and/or other forfeiture conditions. But it may consider making the stocktransferable under certain limited circumstances. Once the stock is transferable, the compensation event is triggered, ordinary income tax is due, and any further appreciation may be long-term capital gains. How to make transferability palatable to all parties is where the ugliness and customization come in. If and when you are ready to pull the big red emergency handle, we can discuss further.

On July 25, 2016 the Internal Revenue Service issued final regulations that eliminate the need for taxpayers to attach a copy of an 83(b) election to their federal income tax returns for the year in which the property subject to the election was transferred, thus clearing the way for such taxpayers to file their income tax returns electronically. (Despite encouraging taxpayers to e-file, the IRS previously didn’t allow taxpayers to attach a copy an 83(b) election to an electronically filed return.)

To be clear, taxpayers still need to file with the IRS a paper copy of their 83(b) election within the applicable 30-day deadline. Taxpayers should keep a copy of the election for at least eight years after disposing of the property to which the election relates (to cover both the standard 3-year and extended 6-year and 7-year statutes of limitations).

The final regulations apply to property transferred on or after January 1, 2016, but taxpayers already were permitted to rely on identical, previously proposed regulations for transfers on or after January 1, 2015.

We are frequently asked the “choice of entity” question for startup companies; that is, whether a client’s newly-formed company should be an LLC or a corporation. Putting aside that LLC’s can elect to be taxed as C or S corporations, the question traditionally translates into tax lingo as a choice between taxation as a partnership versus a C corporation. Now, we tax lawyers love partnerships for the same reasons kids love Legos®, but they are far from optimal for every startup. Every client situation is different, but generally an LLC may be a good idea if the client may want to do any of the following:

1. Distribute operating profits.
Instead of solely a capital appreciation investment, the company will be a “cash cow,” generating operating profits and distributing cash to owners. Notoriously, a C corporation would pay a corporate-level tax (up to 35%), and the shareholders would pay a shareholder-level tax (up to 23.8%) on their dividends. (That’s around 50% before state taxes. Ouch.) If the company were an LLC, it would allocate profits to the members, who would pay a single level of tax, up to 39.6%, with no additional tax if and when the profits are distributed.

2. Exit via asset sales or partial liquidity events.
The C corporation’s “double tax” problem is even more dramatic in the context of capital transactions rather than operating profits. There’s no capital gains tax break for C corporations, so if a liquidity event involves the company’s sale of assets, shareholders face the aforementioned 50% effective tax rate. On the other hand, an LLC would pass the capital gain through to its members, whereupon individual members would only pay the long-term capital gains rate of 23.8%. Most shareholders plan to avoid this problem by selling their stock for one level of long-term capital gain, but a stock sale may not be an option. Buyers may insist on an asset purchase, either for the future tax benefits or to avoid unknown or unwanted liabilities. Additionally, the company may face “partial liquidity events,” where the company separately monetizes some but not all assets. Examples include an investment pool with multiple portfolio companies, a company with multiple divisions or lines of business, or an entity holding intellectual property with multiple applications or fields of use, each of which may be developed and financed through a separate subsidiary.

3. Use tax losses.
Most startups operate at a net loss during their early years (if not their whole lives). A corporation’s losses do not pass through to the shareholders, but rather accumulate as “net operating losses.” NOLs may be carried forward to offset future net income for up to 20 years, but their use may be subject to limitations under the alternative minimum tax (AMT) or rules governing 50%+ ownership changes. An LLC’s losses pass through to the members and may be used to offset other taxable income. This can be a significant benefit – if the member can utilize the losses. Unfortunately, pass-through losses are subject to an array of limitations relating to basis and capital accounts as well as the “at-risk” and “passive activity” rules. In most circumstances, individuals must both (i) contribute their own capital and (ii) be active in the business to benefit from an LLC’s tax losses in the short-term.

4. Use equity as compensation or deal consideration.
In terms of equity compensation for key employees, corporations must choose between granting stock (tax now, capital gain later) or options/phantom stock (tax later but it’s ordinary income). LLCs may issue “profits interests” — potentially the best of both worlds (tax later at capital gains rates). Further, if the startup envisions acquiring other companies with equity, sellers may only receive tax-deferred corporate stock in limited circumstances (e.g., tax-free reorganizations or when the target shareholders take control of the buyer). It is much easier for sellers to receive tax-deferred LLC interests as deal consideration.

5. Implement complex economic structures.
LLCs and other tax partnerships are great for housing complex economic deals among founders, investors, and other equity owners. Examples include multiple tiers of priority distributions and returns of capital, carried interests, different profit splits for particular LLC assets, clawbacks, subordinated common interests, etc. Many of these concepts can be incorporated into a corporate charter with different classes of stock, but only clumsily.

6. Change your mind.
The flexibility of LLCs generally permits do-overs. If you’ve transferred valuable property to an LLC, the company can generally transfer it back to you tax-free. If company is an LLC and wants to convert to a corporation (or elect to be taxed as a corporation), that’s generally tax-free, too. Vice versa? Not so much. Both a transfer of property back to the contributor and the conversion of a corporation into a partnership or disregarded entity are generally taxable events. LLCs also let you change allocations of profits and losses for the year any time before the original due date for that year’s partnership tax return (usually April 15 of the following year). You may want to heed the Book of Common Prayer’s admonition about marriage — a C corporation should be entered into “reverently, discreetly, advisedly, soberly, and in the fear of God.”

On the Other Hand…
Even if a startup company could benefit from pass-through taxation, there are reasons one might affirmatively prefer C corporation status. Most obviously, the administration and accounting are fairly simple; for early stage companies, simple = good. Further, for overlapping reasons, tax-exempt and foreign investors (and the venture capital funds in which they invest) generally prefer owning corporate stock to LLC interests. So-called “qualified small business stock,” which can be sold with no federal tax at all if held at least five years, is only available for the stock of C corporations. Last but not least, executives holding LLC interests may be treated as “self-employed,” which implicates additional complexity and compliance burden. (See here for further information on the “self-employed problem.”)

Takeaway
All planning in life is essentially a prediction about the future. The right choice of entity for a startup company requires reasonable predictions about profitability, expected liquidity events, the usefulness of tax losses, the benefits of tax-deferred equity for compensation and acquisitions, the complexity of the economic deal, and the possibility of changing one’s mind. Weigh these factors against both the administrative complexity of partnership taxation and any affirmative reasons to prefer C corporation status.

As we often do, let’s start with some good news. We have a new partner, Tom Greene, who has been practicing in employee benefits and executive compensation for almost 20 years. In addition to his traditional ERISA practice, Tom is already making a difference in our core M&A practice with his deft handling of 409A, 280G, ISO, plan termination, and benefits diligence issues for buyers, sellers, and management teams.

In Tom’s honor, this edition of the Issue Spotter examines how in-the-money stock options may be useful to growth companies. For this discussion, “in-the-money” means the strike price is below the fair market value of the underlying stock on the date of grant, and “growth company” means a relatively young private company whose equity and option holders intend to profit from capital appreciation in a sale of the whole company (rather than through distributions of operating profits or isolated equity sales).

Fun fact: 409A does not prohibit in-the-money stock options

Conventional wisdom says non-qualified options violate § 409A unless the strike price is at least equal to the fair market value of the underlying stock on the date the options are granted. Ensuring an “FMV strike price” is generally a good idea for business, securities compliance, and other non-tax reasons, but it isn’t absolutely required by § 409A.

To set the stage, remember that § 409A regulates the timing of deferrals and payments for “deferred compensation plans.” Generally, common stock options with an FMV strike price are not deferred compensation plans, and are thus exempt from § 409A. Needless to say, being exempt from § 409A means broad flexibility in designing the vesting and exercise provisions for such options, making one’s life a lot easier.

Options issued in-the-money, however, are deferred compensation plans under § 409A. While they aren’t exempt from § 409A, they can comply with it by, among other criteria, limiting and requiring exercise upon the earliest to occur of one or more of six permissible payment events: death, disability, an unforeseen emergency, a specified time or fixed schedule, and, most importantly for growth companies, a change of control or separation from service.

How in-the-money options may be useful

Here’s what makes in-the-money options a real possibility for growth companies: very few option holders ever actually exercise their options prior to a liquidity event or, to a lesser extent, a termination of employment. It’s only a slight exaggeration to say that a typical option holder would barely notice if his or her options could only be exercised on the earlier of a change of control and/or separation from service. With such restrictions on exercise, the options could comply with § 409A even if the strike price were below the fair market value of the underlying stock when granted.

While not normally the preferred approach, options with a nominal or below FMV strike price may be useful in certain circumstances. Most obviously, the company and a new executive may want the executive to share in proceeds from a sale transaction from “dollar one,” that is, based on the entire per-share value upon the sale rather than just the spread between the sale value and the exercise price. Or two or more employees may join the company and receive options at different times but, for various reasons, wish to receive similar equity compensation packages. Startup advisors will recognize another example — a founder may have verbally promised options to certain employees, and the company may even have adopted an option plan and authorize options grants, but the options are never actually granted to the employees until the company’s stock has substantially increased in value.

Complying with, rather than being exempt from, § 409A has some distinct disadvantages, which is why “FMV strike price” is more common. Most significant is the issue of “subsequent deferral.” Subject to some rare exceptions, in-the-money options (like all deferred compensation plans) must be exercised or cashed out upon the relevant payment event, even if the option holder doesn’t receive sufficient cash to pay the resulting taxes. For instance, the change of control may be a stock-for-stock reorganization with no cash consideration, or the separation from service may not include a sufficient severance package. Drafting around this risk may involve additional advance planning and negotiation.

Takeaway

Issuing stock options with an “FMV strike price” surely makes tax and other legal compliance easier, but it is not absolutely required by § 409A. There are circumstances in which in-the-money options may be useful. Such options comply with § 409A as long as exercise is limited to and required upon certain events, most notably a change of control or separation from service.

As most immigration attorneys, private client attorneys, and other advisors know, a foreign citizen or national is considered a U.S. tax resident if he or she meets the “green card test” or the “substantial presence test.” But the analysis doesn’t stop there. Also consider whether the individual avoids U.S. tax residency through the “closer connection” exception to the substantial presence test, or its close cousin, the “tie-breaker” provisions of tax treaties.

Why It Matters
Obviously, whether a foreign citizen is a U.S. tax resident is an important determination. U.S. tax residents pay U.S. taxes on their worldwide income, while non-residents generally pay U.S. tax only on U.S.-source income. For an individual with income from non-U.S. sources (e.g., pensions, investment income, compensation for foreign employment) who otherwise would pay lower tax rates in a different nation, U.S. tax residency may have a significant price tag. Plus, after eight years, U.S. tax residency becomes like the Hotel California. The Internal Revenue Code is programmed to receive: you can check out any time you like, but you can’t necessarily leave.

Substantial Presence and the “Closer Connection” Exception
Although “183 days per year” is a well-known touchstone of the substantial presence test, the true threshold is lower than that. Because days present in the U.S. in the preceding year each count as 1/3 of a day, and in the second preceding year count as 1/6 of a day, spending an average of 122 days per year in the U.S. will make one a U.S. tax resident.

Enter the closer connection exception. Notwithstanding substantial presence, and assuming no green card or green card application, an individual will not be a U.S. tax resident if he or she: (1) spends fewer than 183 days in the U.S. in the current year; and (2) has a “tax home” and a “closer connection” in another country.

For this purpose, an individual’s tax home is considered to be his or her main place of business, employment or post of duty. If none of these apply, the tax home will be where the individual resides for a majority of the time. Whether an individual has “closer connection” with a foreign country is based on all the facts and circumstances, including the residence claimed on official documents, place of voter registration and driver’s license, where he or she derives a majority of income, and the location of family, permanent home, personal belongings, furniture, cars, banks, and personal, financial and legal documents.

Treaty Tie-Breaker for Dual Residents
If an individual cannot satisfy the closer connection exception (e.g., spends 183 days or more in the U.S. during the year), there may still be hope under an income tax treaty’s “tie-breaker” provisions.

The U.S. has tax treaties with dozens of foreign countries, principally intended to help residents of one country avoid being taxed by the other country based on temporary travel or business connections. For instance, tax treaties typically prevent a country from taxing business profits or compensation earned by the other’s residents unless the income is connected to some non-temporary physical presence, termed a “permanent establishment” or “fixed base.”

Sometimes, an individual is a “dual resident,” i.e., the individual qualifies as a resident of both countries under their respective tax laws. For example, an individual may meet the substantial presence test in the U.S. but also spend enough time in the other country to be treated as a resident under its own laws. Enter the “tie-breaker,” which in most treaties reads like this:

Where … an individual is a resident of both Contracting States, then his status shall be determined as follows:

he shall be deemed to be a resident only of the State in which he has a permanent home available to him; if he has a permanent home available to him in both States, he shall be deemed to be a resident only of the State with which his personal and economic relations are closer (center of vital interests);

if the State in which he has his center of vital interests cannot be determined, or if he does not have a permanent home available to him in either State, he shall be deemed to be a resident only of the State in which he has an habitual abode;

if he has an habitual abode in both States or in neither of them, he shall be deemed to be a resident only of the State of which he is a national;

if he is a national of both States or of neither of them, the competent authorities of the Contracting States shall endeavor to settle the question by mutual agreement.

Note how the tie-breaker resembles the closer connection analysis, especially with respect to determining where “personal and economic relations are closer (center of vital interests).” Once again, driver’s licenses and the location of family and bank accounts will be part of the discussion.

Some words of caution: For the tie-breaker to apply, the individual must be a “resident” of the other country under that country’s own domestic tax laws. This may not be obvious, particularly because unlike the U.S., most countries do not automatically treat their citizens as tax residents. Consultation with a tax advisor from the individual’s home country may be necessary.

Moreover, the tie-breaker governs the dual resident’s residency only for purposes of determining the individual’s U.S. tax liability. It does not absolve the individual of U.S. tax reporting obligations. The individual must still file Form 1040NR to report U.S.-source income and Form 8833 to claim treaty benefits. Form TD F 90-22.1 to report foreign bank accounts and Form 8938 to report other foreign assets may also be required. A tax return preparer with experience working with nonresidents is highly recommended.

Furthermore, a dual resident will still be treated as a U.S. resident in determining another person’s tax liability. For instance, a dual resident may still be counted as a U.S. shareholder in determining whether a foreign corporation is a “controlled foreign corporation” whose “subpart F income” is immediately taxable to other U.S. shareholders.

U.S. Citizens and Green Card Holders
Neither the closer connection exception nor a treaty’s tie-breaker provisions are of any help to a U.S. citizen, including a dual citizen. The Internal Revenue Code treats citizens as per se tax residents, and U.S. tax treaties contain a “savings clause” reserving the IRS’s right to tax U.S. citizens notwithstanding any treaty.

Like citizens, green card holders are per se residents under U.S. tax law, meaning the closer connection exception does not apply. But nothing in a tax treaty precludes green card holders from availing themselves of a tie-breaker provision. That said, U.S. immigration law may treat a claim of nonresidency (even one solely for tax purposes) as a constructive surrender of one’s green card. Tread very lightly and consult a good immigration attorney.

Takeaways
Just because a foreign citizen or national meets the “substantial presence test,” the individual is not necessarily a U.S. tax resident. Always consider whether the closer connection exception or tie-breaker provisions of a tax treaty apply. With respect to tie-breakers, one must further consider the individual’s remaining U.S. tax reporting obligations and the effect of filing a Form 1040NR on the individual’s immigration status.

This edition of The Issue Spotter concerns how to avoid phantom income on the conversion of bridge notes with accrued interest. The common scenario is that, in anticipation of a round of VC financing, a company raises cash in exchange for “bridge notes.” The notes typically convert into the same series of company stock sold in the next round at some modest discount (maybe 10%). The structure is often driven by uncertain valuation, that is, the company can’t or doesn’t want to set its pre-money value before negotiating the terms of the next equity round. The bridge notes are a convenient way to give the new investors a liquidation preference but adopt a “wait and see” approach to valuation.

The tax impact of converting accrued but unpaid interest on the notes is seldom foreseen amid the other pressures of a bridge note financing. To illustrate, let’s imagine a company issues a bridge note for $1 million that bears 8% interest and is converted into preferred stock 1 year later. The preferred stock received in respect of the $1 million principal is tax-free. But the preferred stock received in respect of $80,000 in interest is taxable income (subject to special rules for tax-exempt and foreign investors). The tax bill may or may not be affordable, but it will almost certainly be a surprise. And neither the company nor the investor may have sufficient cash to pay the tax – the IRS doesn’t accept series B certificates as a medium of payment.

Consider Waiving Interest or Treating as Equity

As with most problems in life, this one can be avoided with a little planning. One crude but effective solution is to waive the interest, that is, provide in the original notes that the interest is payable in cash upon maturity but is waived upon conversion. A surprising number of investors are amenable to this solution because, psychologically, the interest was never a part of their expected economic return. Their investment goal was to own preferred stock and their risk was compensated through the conversion discount.

But our own favorite solution is to declare in the original notes that, for tax purposes, the investment will be treated as equity rather than debt. Instead of taxable interest, the 8% return is treated for tax purposes as a stock distribution, which in this context is normally tax-free. The “cost” of this solution is that the company loses its interest-paid deduction, which is a startup accumulating tax losses doesn’t need anyway. True, the terms of the note will need to be more equity-like than debt-like, thus jeopardizing the “debt” status of the notes in bankruptcy. But unfortunately, the note holders of an insolvent startup company inevitably take on the role of “owners,” voluntarily or not.

Equity treatment has additional, collateral tax benefits. In addition to creating a potential tax liability, interest can be a terrible hassle to compute, especially under the complex rules for “original issue discount” and “contingent payment debt instruments.” An investor’s holding period in the stock would begin upon issuance of the bridge note, which may be important for taking advantage of the lower tax rates for long-term capital gain or qualified small business stock. Finally, in a distress situation, the company avoids the possibility of “cancellation of debt income” if the notes are converted into equity with a value lower than the outstanding debt.

Drafting Tips

Whether a financial instrument is debt or equity for tax purposes depends on all the facts and circumstances, so there are no magic words. That said, you’ll want a simple statement to the effect of “the parties intend this instrument to be equity for U.S. tax purposes.” Ways to grant equity characteristics to a note include: (i) eliminating interest accrual; (ii) deferring maturity indefinitely until a liquidity event or dissolution; (iii) eliminating “creditor remedies” on default; (iv) granting note holders voting and dividend rights comparable to shareholders; or (v) limiting interest payments to the company’s retained earnings, in a manner similar to dividends.

Bridge financing instruments with equity characteristics are rapidly entering the mainstream. For instance, prominent startup accelerator programs are promoting documents that utilize the first three factors described above – eliminating interest, deferring maturity indefinitely, and eliminating creditor remedies. They’re publicly available – Y Combinator’s Simple Agreement for Future Equity (“SAFE”) at ycombinator.com/documents and 500 Startups’ Keep It Simple Security (“KISS”) at 500.co/kiss. There are several variations on each agreement, some investors may find them too company-friendly, and they make no mention of tax treatment, so they’re a good starting point if not completely plug-and-play.

Takeaway

When bridge notes convert into stock, any stock received in respect of accrued interest may be unexpected phantom income. Plan ahead by drafting the bridge notes to manage or avoid this issue, perhaps by providing for the interest to be waived on conversion or by treating the entire note as equity for tax purposes. Model bridge financing documents with equity characteristics are publicly available, so they’re worth a look.

It seems like every year I send an urgent newsletter advising corporate transactional lawyers that an 11th hour tax bill has opened a short window for some tax-advantaged transactions, and 2014 is no different. Thank the lame-duck Congress for the Tax Increase Prevention Act of 2014 (TIPA), which breathes one more year of life into several taxpayer-friendly laws that had expired at the end of 2013.

Among the so-called “tax extenders” are a few provisions of particular interest to entrepreneurs and small-to-medium size businesses. These extensions are retroactive to the beginning of 2014, but will expire (unless extended again) on December 31.

Be on the lookout for the following last-minute, tax-saving transactions:

Acquire qualified small business stock (QSBS). The 0% tax rate (hard to get lower than that) for QSBS has been extended for stock acquired during 2014 (and thence held for 5 years). It’s unlikely you’ll start a new company in the next eight days, but you can acquire QSBS in other ways on short-notice:

Convert an LLC to a C corporation. This may be useful if you believe the LLC will convert to a C corporation anyway. You don’t even have to form a new entity – you can file Form 8832 to elect for the existing entity to be taxed as a corporation.

Exercise options. If the stock you receive is unvested, you will likely want to file a Section 83(b) election.

Convert notes. This may be useful if you hold bridge notes that will convert into preferred stock at the next financing. Depending on the circumstances, you might convert into stock now and adjust the purchase price later.

Purchase equipment. Special expensing and depreciation provisions have been extended through December 31. You can immediately write-off up to $500,000 of depreciable business property and take 50% bonus depreciation on even bigger purchases.

Sell the assets of certain S corporations. This is an additional benefit for S corporations that converted from C corporation status at least 5 but fewer than 10 years ago. Generally, the “built-in gain” in a C corporation’s assets remains subject to double-tax for 10 years after the S election. That 10-year period is reduced to 5 years for assets sold in 2014.

Redeploy capital in foreign subsidiaries. This one is technical but a significant benefit if you own multiple “controlled foreign corporations.” Generally, moving cash around related CFCs through the payment of dividends, interest, rents, and royalties can trigger immediate US tax liability for certain US shareholders unless (among other conditions) the payment is between corporations organized in the same country. Through 2014, related CFCs can pay dividends, interest, rents, and royalties to each other regardless of their country of organization if certain conditions are met (generally, if the payment is attributable to the income of an active business conducted outside the US).

Not all taxpayers will benefit from these opportunities, and as always there are hoops and fences to jump through and over. You should consult a good, independent tax advisor to determine whether and how these tax advantages apply to you and your clients.

Take Caution with Certain Employees

You have likely heard of the tax benefits of an LLC or other tax partnership issuing “profits interests” to executives and other service providers. Whereas with C and S corporations there is a tension between issuing stock (for long-term capital gains upon a liquidity event) and options (to avoid immediate taxable income), profits interests combine the best of both worlds. Be cautious, however, about issuing profits interests to rank-and-file employees. Being a partner in a tax partnership involves certain complexities that can be burdensome and confusing to workers who are not accustomed to being “self-employed.”

Partners are Self-Employed

The root of the problem is that, for tax purposes, a partner who provides services to a partnership is “self-employed,” and not an “employee.” Put another way, an individual cannot be both an employee and a partner in a tax partnership. Being self-employed has some advantages, such as the full deduction of an individual’s business expenses and access to IRAs and other retirement savings plans for the self-employed. When it comes to tax withholding and benefits, however, self-employment may hold unpleasant surprises.

No More Payroll Tax Withholding

In addition to equity in the company, a profits interest holder may also receive a salary or other compensation for services. Unlike with an employee, a partnership does not withhold income taxes from payments to a partner. Instead, a profits interest holder must pay “estimated taxes” quarterly throughout the year. Obviously, estimated taxes require additional returns and the habit of putting aside a portion of one’s paycheck to pay them.

Similarly, the company does not withhold the so-called “FICA” taxes for Social Security and Medicare. Worse (from the worker’s perspective), the company doesn’t pay the “employer-half” of such taxes. Instead, a profits interest holder is subject to “self-employment tax,” which tries to replicate the FICA taxes that would have been due, combining the employer’s and employee’s shares, and including the Social Security cap ($117,000 for 2014) and deductibility of the employer-half. As with estimated income taxes, there is the burden of filing and reserving for self-employment taxes, and bearing the employer-half may cost a worker up to 7.65% of his or her compensation in extra taxes.

Exclusion from Certain Employee Benefits

A profits interest holder’s self-employed status extends to the company’s health and welfare benefit plans. First and foremost, you will want to consult with an employee benefits expert to determine if the company’s plans can and do apply at all to the company’s equity owners. Even if they do, self-employed individuals are not eligible for certain tax-advantaged benefits, such as parking and transit subsidies and health care flexible spending accounts, but they remain eligible for others, such as educational and dependent care assistance.

Most consequential for the majority of workers is the question of employer-subsidized health insurance. Normally, an employer’s contributions to an employee’s health insurance premiums are not taxable income to the employee. This doesn’t apply to the self-employed, and the profits interest holder would be taxed on the company’s health insurance subsidy. The profits interest holder may, however, be able to deduct all of his or her health insurance premiums under certain conditions, the most important of which is the individual is not otherwise eligible for employer-subsidized health insurance through another job or family member. This health insurance deduction for the self-employed may be just as good or even better than an employer subsidy, but the individual-specific eligibility standards make this difficult to plan for among large groups of workers.

Work-Arounds

As you can see, the prospect of adapting to estimated and self-employment taxes, and changes to health insurance and other benefit plans, may be daunting to a rank-and-file employee receiving a small percentage interest in an LLC or other tax partnership. The practical “work-arounds” seek to prevent an individual from being both a partner and an employee of the same entity. These include inserting an S corporation holding company to hold the profits interest, allowing the individual to remain an employee while the S corporation (and not the individual) is the partner. Generally, the more employees are involved, the more difficult it is to implement these types of work-arounds.

The alternative is to avoid the workers becoming partners at all by issuing them options or phantom equity instead of “real” equity. The employees will realize ordinary income upon exercise or payment, but the company’s owners will receive an equivalent deduction for compensation-paid. If the owners are in a higher tax bracket than the employees (and can utilize the deduction), options or phantom equity can be very tax-efficient, and the company could consider making the employees whole by issuing additional options, phantom equity, or simply cash bonuses.

Takeaway

Profits interests are great; they represent one of the biggest tax advantages of partnerships. Absent a customized work-around, however, profits interests will render the holder “self-employed,” and that comes with significant tax complexity. As a rule of thumb, think twice about issuing profits interests to employees who have not previously been self-employed or who don’t have their own sophisticated tax advisors. Sometimes the game isn’t worth the candle.

Earlier this month, Travis was featured in the BNA Daily Tax Report, speaking about the implications of the Sun Capital case. In Sun Capital, the First Circuit Court of Appeals surprised most of the tax world in ruling that, for ERISA purposes, a private equity limited partnership was engaged in a “trade or business.” If that conclusion were to hold true for income tax purposes, and investment funds holding the securities of portfolio companies were treated as engaged in a trade or business, the tax consequences for tax-exempt organizations, foreign investors, and the carried interest for fund sponsors would be dramatically negative.

Although the implications for private equity received the most attention, the author of the article was correct in putting front-and-center the consequences to ordinary entrepreneurs of using Sun Capital to tax carried interests as ordinary income without special legislation. To wit, a private equity sponsor is, at least tax-wise, in much the same position as an entrepreneur who both works at and invests in his or her own business. Let’s imagine that Raj and Louise start a software company, which they own through an LLC. Sure, they’re putting their labor into it, writing the code for which they receive a reasonable salary. But this endeavor is also about capital appreciation, and when they develop a kickass software program and sell the assets for $80 million, they’re going to be taxed at capital gains rates. Under the current law, private equity sponsors who earn a carried interest by improving the value of portfolio companies are in the same position.

It’s up for debate whether ordinary income and capital gains should be taxed differently, or whether Congress should enact special legislation taxing carried interests at ordinary rates. But the fact is that active participants in a business are earning capital gains every day in the American economy. Trying to twist Sun Capital to target such gains would hit Main Street far more than it would Wall Street.

Most will agree that the technical tax allocation sections of most partnership agreements or LLC operating agreements are just unreadable. No socially well-adjusted human being, and by that I mean a person who isn’t a tax lawyer, reads the endless paragraphs on “qualified income offset,” “partner nonrecourse minimum gain,” and “Section 705(a)(2)(B) expenditures” and derives any useful information about the parties’ business arrangement, which is the point of language in any contract.

Once upon a time, the now-familiar tax boilerplate was novel and useful. From the mid-70s through the early 90s, Congress and the IRS promulgated a wave of new laws and regulations to shut down individual tax shelters. Through nonrecourse loans and manipulations of partnership tax accounting, these shelters allowed taxpayers to claim large ordinary losses without having to actually lose money, and take cash distributions without recognizing taxable income. The resulting rules gave birth to terms like “substantial economic effect,” “minimum gain chargeback,” and “adjusted capital account deficit.”

It’s believed that William McKee and William Nelson first popularized long and descriptive recitations of the new tax regulations in the form agreements published with their famous treatise on partnership taxation. The rest of the bar soon followed suit, which one could blame on conformity, but there was an educational function, too — for lawyers, accountants, and clients alike.

With due respect for our forebears, I believe the novelty and usefulness of the long-form tax section has passed. A few million cut-and-pastes later, it’s just clutter. The forms often don’t get updated, and inaccuracies creep into the language and section references. Its lessons on using capital accounts and the need for allocations of income and deductions to have real-life economic consequences have become common sense. Other tax law innovations, such as the passive activity rules, have shut down individual tax shelters in their own right. Most of all, its regurgitation of the law is largely superfluous. How to calculate partnership minimum gain is governed by the regulations, regardless of what your agreement says. We don’t need 12 defined terms and 5 pages of agreement text to tell us what the law is.

Now, we can’t just chuck it all. Many necessary concepts only apply if “provided for in the partnership agreement,” so we must at least incorporate them by reference. And of course the central provision on how to allocate profits and losses is driven more by the business agreement than by law; it must be customized on a deal-by-deal basis.

So I’ve drawn up a new model of standard allocation provisions in the form of a hypothetical Article IV to an LLC operating agreement based on two guiding principles. First, shift as much ministerial detail to the tax regulations as possible. Second, when it comes to accounting choices, such as which method to use for Section 704(c) allocations, give the choice to management. When the choice becomes relevant, they can run the numbers and decide upon a mutually acceptable solution. You don’t trust management? Then pay attention to what’s discretionary, and either negotiate a choice ahead of time or settle upon a dispute resolution mechanism for making the choice later. But even with such customizations, I believe the new form is technically sound for tax lawyers, user-friendly for non-tax lawyers, and cost-effective for clients.

DISCLAIMER: I’m sharing my new form to let you know what I’m doing. Feel free to use or share, royalty-free, as my contribution to improving the practice of tax law. But I’m not (yet) your lawyer. Always have a tax attorney review your partnership or operating agreements. I’m just suggesting a way to make that review faster, cheaper, and less annoying. Enjoy.